Constellation Energy Corporation (CEG) — Q2 2022 Transcript

Thank you, Liz. Good morning, everyone, and thank you for joining Constellation Energy Corporation's second quarter earnings conference call. Leading the call today are Joe Dominguez, Constellation's President and Chief Executive Officer; and Dan Eggers, Constellation's Chief Financial Officer. They are joined by other members of Constellation's senior management team, who will be available to answer your questions following our prepared remarks. We issued our earnings release this morning, along with the presentation, all of which can be found in the Investor Relations section of Constellation's website. The earnings release and other matters, which we will discuss during today's call, contain forward-looking statements and estimates regarding Constellation and its subsidiaries that are subject to various risks and uncertainties. Actual results could differ from our forward-looking statements based on factors and assumptions discussed in today's materials and comments made during this call. Please refer to today's 8-K and Constellation's other SEC filings for discussions of risk factors and other circumstances and considerations that may cause results to differ from management's projections, forecasts and expectations. Today's presentation also includes references to adjusted EBITDA and other non-GAAP measures. Please refer to the information contained in the appendix of our presentation and our earnings release for reconciliations between the non-GAAP measures and the nearest equivalent GAAP measures. I'll now turn it over to the CEO of Constellation, Joe Dominguez.

Thanks, Liz, for getting us started and thanks to Vice President Duncan for her preliminary remarks, otherwise known as Emily to all of us. I want to thank all of you for joining us this morning and for your continued interest in Constellation and our mission to provide reliable, clean energy to families and businesses across America 24/7, 365. Of course, as we talk this morning, all eyes are focused on Washington and the proposed Inflation Reduction Act, which would be clearly transformational for Constellation, both in terms of support for our clean energy nuclear assets as well as creating new opportunities for clean hydrogen production and fuels. I'm going to talk a little bit more about that in a minute. But Dan and I will focus most of our time on the excellent quarter we just completed and the strong numbers and operational performance across Constellation. As always, I want to begin with a shout-out to our talented women and men who work at our plants, sell power to our customers and work in our corporate centers. I know a few of you listen in to these calls, and we want to thank you for everything you do for Constellation. As you've no doubt read in the release, turning to Slide 5, Constellation posted a second quarter EBITDA of $603 million, and we reaffirm our full year guidance. Our balance sheet continues to give us a competitive advantage in the market, and customers are increasingly utilizing our platform of sustainability solutions, setting the stage for the launch of our 24/7 product. Dan will walk you through the financial results in his remarks, and I've asked him to spend a few minutes this morning reminding you of how our hedge program works. Turning to Slide 6. As you know, our people have led the way on the development of policies that support the continued operation of baseload clean energy nuclear assets. They produce the bulk of America's emissions-free energy 24/7, 365 days a year. So we're pleased to have that small role in the crafting of the historic federal energy bill that, we believe, is on the cusp of success. It recognizes the vital role of clean nuclear energy. The drafters of the IRA reached the same conclusion that many of our states have already reached, namely that without baseload nuclear assets, we don't stand a chance of achieving our climate objectives, our affordability goals, or the need to have reliable and resilient power on the grid that could withstand the extreme weather we increasingly face. The provisions in the IRA not only support the continued operation of our assets but create policy support, which, if extended, supports the 80-year license life that our assets could operate to, giving Constellation and its owners long-term clarity. Let me put this in context for you. By extending the licenses out to 80 years, our existing fleet of clean energy nuclear plants would have an operating life that is longer than any new renewable energy source that will be put on the grid this decade. But it's not just the longevity and the electricity side of it that excites us. It's what we could do to provide sustainable jobs for the future of our industry and ensure that those jobs create opportunities where opportunities are needed. From a job standpoint, extending the licenses at our plants to 80 years will create over 453 million people hours of work in high-paying jobs across the country, making the nuclear energy provisions of the IRA one of the largest creators of family-sustaining wages. The provisions concerning clean hydrogen, specifically the ability of nuclear plants that earn both the nuclear PTC and the hydrogen PTC means that nuclear plants will become a key cog in clean hydrogen and sustainable fuels. States that took early action to preserve their nuclear plants should be able to receive credit from the PTC payments so that state consumers get the benefit of the federal programs, and work is underway to achieve that result. All told, here's how we see it. Passage of the IRA would be a win-win-win. It preserves and extends baseload clean energy resources that are vital to America's energy mix and our fight against the climate crisis. It preserves thousands of family-sustaining jobs and creates even more jobs. And it saves consumers money in states that have preserved these assets. For you, our owners, it means this: it resets Constellation's value as a critical infrastructure company with strong and more predictable financial results, unique growth opportunities, and long-term durability on par with anyone. Turning to Slide 7 and our generation highlights. Our fleet performed extremely well during the quarter. Let me start with the fossil and renewable fleet, focusing on Texas. During the extreme heat in July, our plants ran as expected with minimal outages, all of which were scheduled with ERCOT to occur at times that would not impact the grid. Our generation fleet's performance reflects the investments we've made in Texas along the way and shows how well we are positioned as a portfolio in Texas to serve customers well during extreme heat and price volatility. Our clean energy nuclear plants had a 94.2 capacity factor and power and renewables achieved excellent results. In July, our data indicates that our nuclear plants ran at over 98%. I remind you, this is different than any other resource in the market in terms of its ability to withstand temperature fluctuations and operate 24/7, 365. There is no other clean energy resource out there that does anything near that. In fact, when our nation saw unprecedented heat, the performance of the U.S. nuclear fleet as a whole saved lives, providing baseload clean energy during times of record demand. As we see the continued evolution of the stack and the move away from fossil fuels to more intermittent forms of generation, we think the importance of these assets will only grow over time. Turning to our commercial business and the summary on Slide 8. It once again performed very well during the quarter, with strong volumes of electricity and gas delivered to our customers. We closed several deals providing carbon-free solutions to help customers meet their sustainability objectives. Customer renewals picked up significantly compared to the first quarter as we saw more customers come forward and be willing to engage. We doubled our renewal volume, making Q2 the best second quarter of renewals in 3 years. These renewals and our commercial and industrial business generally are an important part of our hedging strategy, which Dan will talk about in a moment. In addition, we're seeing margin expansion across the retail and wholesale channels, recognizing the higher risks in the market due to volatility. We also executed some of our largest core deals to date. Core deals, as a reminder, help our customers meet their carbon and energy goals, but they also support the development of new and additional renewable megawatts being added to the grid. We've highlighted a number of our customers, particularly Bank of America and P&C, who entered into significant deals. In the future, our 24/7, 365 product will include nuclear energy as companies endeavor to reach even greater levels of sustainability by load matching their consumption with power produced at the same time. This will be a natural evolution of the core energy product and other sustainability products we have in the market. In terms of our commitments, Slide 9 reminds you of what they are. We must do more as a nation to increase our clean generation and reduce emissions, and we have to help customers do the same. The transactions I just talked about with our business partners are part of leveraging our key advantages in helping them meet their sustainability goals. But as we talked about on Analyst Day, to provide all of our commercial and industrial customers with the information they need, we need to give them reports explaining where they are on their path to sustainability. I'm pleased to say that at the end of this month, we're going to have that available to every one of our customers. Our carbon commitments are to grow our carbon-free generation to 95% of our output by 2030 and 100% by 2040, subject to policy and technology. That means we will reach zero emissions from generation by 2040, not net zero, but zero. We're going to reduce our baseline operations-driven emissions to zero from a 2020 baseline. When we announced these commitments on Analyst Day, which was just 6 months ago, we did it intending to set the bar in the industry and to be a leader. It's fantastic to see that other companies are now following in our footsteps, and I commend those companies and their leadership. We have to keep pushing each other. Turning to Slide 10. This slide should be familiar to you, and I want to walk through it quickly before I turn things over to Dan. We intend to deliver value to our shareholders through our capital allocation strategy. We are on track to provide you that update later in the year. We are committed to maintaining a strong investment-grade credit rating, which provides us a competitive advantage. You've seen that advantage play its role in our success already in the 6 months of this company. We'll provide $180 million of annual dividend growing at 10%. We believe there are other opportunities to grow our business organically and inorganically, and we will seek those opportunities, provided that they exceed a double-digit return threshold. If we don't find those opportunities, we're going to return capital to our owners through special dividends or share buybacks. Again, we'll see what happens with the IRA. We'll gauge the market reaction to inform our decisions. We are committed to providing you that information this year. I've heard some chatter and questions out there that maybe that slips; it's not going to slip. We will provide that information to the market. Now let me flip it over to Dan.

Thanks, Joe, and good morning, everyone. Starting on Slide 11. We had another strong quarter financially, earning $603 million in adjusted EBITDA. As expected, year-over-year EBITDA was slightly lower. We benefited from higher realized energy prices and lower nuclear fuel costs, driven by the absence of accelerated amortization of fuel at Byron and Dresden. This was primarily offset by lower capacity revenues from both cleared megawatts in the Midwest and lower prices across PJM and New York. Higher nuclear outage costs were driven primarily by a long refueling outage at Salem and additional maintenance during our Byron following the reversal of the retirement decision last fall. We are reaffirming our full-year adjusted EBITDA guidance of $2.35 billion to $2.75 billion. As a reminder, we saw some favorability in the first half of the year by selling output from Byron and Dresden at higher prices after the retirement reversal due to the passage of the Clean Energy Jobs Act. As of June 1, Byron, Dresden, and Braidwood all shifted to the first 12-month cycle under the 5-year CMC program, with revenue starting at $30.30 per megawatt hour. This price is lower than the prices we realized for Byron and Dresden in the first 5 months of this year. We plan to provide an update for our 2022 EBITDA guidance range on next quarter's call. Turning to Slide 12. Since we launched in February, we've gotten a lot of questions from both new and legacy investors about our approach to hedging, including how and why we hedge. So I'm going to spend a few minutes revisiting our hedging program. From a business perspective, there are several reasons why we hedge as we do. First off, we serve 215 terawatt hours of retail and wholesale electric load annually in our commercial business, which accounts for the majority of our forward power sales. Our C&I customers generally sign contracts on a multiyear basis with an average term of at least 2 years and are often signed as long as 6 months before going into effect. Each year, 60 to 70 terawatt hours of these contracts come up for renewal, where we have a renewal rate around 80%, depending on the year. We typically win 1 out of every 3 new contracts where we seek to add customers. This leads to a consistent stacking of contracts that effectively takes the shape of 1/3, 1/3, 1/3 over 3 years. Matching our generation output to these customer needs provides transaction efficiency and liquidity, particularly in the out-years. Second, the CMC mechanism in Illinois represents about 27% of our generation, creating a hedge for the next 5 years. With the run-up in power prices over the last 12 months, the contract prices are now below market and benefiting the Northern Illinois customers. As you know, the Illinois plants would have shut down without the CMC law, so we would have been receiving no revenues at these sites without the law. Instead, we are now in a position to potentially extend the licensed lives of these strong dual-unit sites, improving both the duration and economic value of these assets. Third and foundationally, delivering on our financial covenants is of utmost importance, and our hedging program allows us to do that by providing certainty in near-term earnings and cash flows. Improved visibility helps us in several ways by supporting the balance sheet and our investment-grade credit ratings—a competitive advantage clearly seen in these recently volatile commodity markets—and providing confidence in our capital allocation decisions, including long-term investment needs and return of capital to shareholders. We do have some flexibility within our hedging program to be opportunistic when we see attractive prices or pull back when we don't. We'll manage the portfolio accordingly to capture the most possible value as we see market conditions. You've heard this from us since our Analyst Day, meeting our financial commitments is paramount to us, and our hedging program allows us to meet these commitments, delivering value for our shareholders. Now turning to Slide 13. We provided an update to our gross margin disclosures, which is marked to June 30, 2022, for prices and positions. Looking at the table, you can see that the total gross margin for 2022 is unchanged from March 31 as we are nearly 100% hedged across the major regions. Open gross margin is up significantly since the first quarter earnings call due to the increase in power prices across all major regions, offset by the mark-to-market of hedges since we are effectively fully hedged. The commercial team continues to perform well and executed $100 million of new business during the quarter. In 2023, total gross margin is up $200 million since last quarter to $8.15 billion. Open gross margin is up $500 million, partially offset by the mark-to-market of hedges and execution of $50 million of new business during the quarter. Across all regions, we capitalized on higher prices during the quarter, executing sales at price levels well above those of previously executed hedges. We are now 88% to 91% hedged across our portfolio. We've all observed the dramatic increases in forward gas and power curves over the past 12 to 18 months. An interesting phenomenon is also worth noting: the steep backwardation in the curves across our regions, with 2022 and '23 significantly higher than the out-years. There was around $30 a megawatt hour of backwardation in the forward groups at NI Hub and West Hub between 2022 and '24. This steepness in the curve is unique. Looking back at history, the past 3 years' backwardation would have been about $3 to $5 per megawatt hour, and the curves are relatively flat when we look back to the 3 years before that. I talked about the importance of our retail customers a few moments ago. Many of our retail power customers sign multiyear contracts at a fixed price, providing them with the visibility and certainty they need to manage their businesses and budgets. However, when combining a fixed-price contract with a steep backwardation in the commodity curve, we've been running into some margin pressure in the near term as we deliver at a lower-than-market price and then make up for the pressure in the out-years when the cost to serve is then lower than the fixed price contract. We are managing through this headwind, but I wanted to flag this since these are different market conditions than we've encountered before. I should stress, as Joe pointed out, we have seen some margin improvement this year. There's a little bit of a timing phenomenon, but operationally, this is a good outcome for us. Turning to the financing and liquidity update on Slide 15. Our credit metrics remain very strong. We have a BBB- rating at S&P with a positive outlook and a Baa2 at Moody's with a stable outlook, and our metrics are 10% to 20% higher than our downgrade thresholds. As a reminder, we have already retired or paid down nearly $2.5 billion of long-term debt and term loans this year, completing our debt paydown for the next 2 years. The value of having an investment-grade balance sheet continues to grow and provide competitive advantages in today's market. We continue to be in a strong liquidity position, with more than $2 billion in unused capacity and a cash balance of $800 million as of June 30. We have received many questions about our pension since the separation. As of June 30, our pension-funded status is just over 93%, which has improved since year-end due to a combination of the $192 million pension contribution we made in February and the positive impact from higher discount rates on the liability that have collectively more than offset the impact of asset returns. As a result of the higher-funded status, we've been derisking the asset mix of the portfolio, which has helped to mitigate the impact of negative equity returns in the first half of this year. We will run a full remeasurement of our pension, OPEB, and related trust assets at year-end in normal course. Any changes that differ from the assumptions previously embedded in our projections are recognized over time rather than immediately in our financials. Therefore, such changes will have no impact on our current year earnings. Our financial strength sets us apart from others in the market and provides us with more opportunities to transact in volatile markets, where margins expand as risk is more appropriately reflected in pricing. We are better positioned to service our customers while meeting any additional collateral postings without the need for additional liquidity and those associated costs. I'd like to now turn the call back to Joe for his closing remarks.

Thanks, Dan. I want to just close by summarizing Constellation's value proposition. It was a decade ago that we were really beginning this discussion about the importance of preserving the nuclear plants. A lot has changed during that period of time, and particularly over the last year or two, where you've seen some of the poor policy decisions that in closing these plants have impacted electricity prices, reliability, and, of course, the fight against the climate crisis. It's great to see this package coming together in Washington, and we're confident it will pass and really change America. We believe we are a unique company that cannot be replicated. We own 25% of the U.S. nuclear fleet and produce 10% of the carbon-free energy, nearly twice as much as the next largest carbon-free generator. These plants could run for 80 years, well beyond 2050, in most cases. We provide power to nearly 23% of all competitive commercial and industrial customers in the U.S., three-quarters of the Fortune 100. This positions us to meet the growing demand for customer-driven carbon-free energy and sustainability solutions. We think we're the best operator of nuclear plants in the country, and the metrics back that up. We thrive in times of volatility, as both Dan and I discussed earlier. We generate strong free cash flow through our best-in-class operations, retail and wholesale platforms, and we support clean energy across the country with a good focus on cost and reliability. We have a strong balance sheet, and our investment-grade credit rating is extremely valuable. We deliver value to our shareholders through disciplined capital allocation. I'll now turn it over to the operator for questions.

Well, Joe, you even got the operator excited. So I think that's the first.

Well, we thank Liz for that. Enjoy the show. She's a shareholder.

Yes. So this bill's not passed yet, and so I just want to get a little more color on your confidence, such confidence that it's going to get done, and also make sure that the corporate minimum tax provisions would not impact Constellation.

Yes, Steve, thanks for the question. When we talk about our cash tax exposure, we've noted that we certainly will be over the $1 billion pretax earnings threshold as we look forward, so we'll qualify in that sense. We've identified that we expect our cash tax rate to rise from a modest payer this year to a more meaningful payer next year and the years beyond. By 2023, our cash tax rate would be above the AMT under all circumstances. We would expect to be a cash taxpayer, absent the PTC, once that goes into effect in '24. We'll manage the credits to cover our tax liabilities and leverage the transfer market to monetize those that wouldn't fit under the AMT construct.

Thanks, Dan. And Steve, regarding your question on the IRA, there's been substantial work done, and we're pretty close. What we're seeing aligns with what everyone following the bill is seeing—strong progress. Getting managed on board was key. Senator Sinema is out there, with reports of some, what I would describe, modest changes to the bill. If that all holds true and the parliamentarian gets the work done, we see a pathway to passage here in August, and then the house will review it when they return from recess. There’s no reason at this point for us not to feel confident.

No, I think that's right. Steve, you've followed us long enough. You've seen hurdles being cleared over the last couple of months. There are a couple of remaining issues, as Joe said, with the tax title and the energy title, but we're getting close.

I wanted to touch a little bit on the cost side of the business. Given the inflationary pressures, are the multiyear guidance for O&M and maintenance capital still valid? Or are you starting to see some pressure on those numbers?

Paul, I think we're starting to see some labor pressure like everyone else. But we benefit from a few things here. For the O&M at our plants, we have long-term agreements to support the operation of the plants, which have built-in escalators of 2% to 3%. Most of our significant labor agreements are also locked in, some through 2027 at 2.5%. We're not immune to inflationary pressures, but we find ourselves in a strong position. We carry a significant nuclear parts inventory in-house, allowing us to recover quickly from maintenance events—this is an advantage because it’s already paid for and ready to go. Dan, do you have anything more to add on that?

I think that covers it. We’ll keep an eye on all factors, but certainly, between the labor deals that we have and the supply contracts, we aren’t seeing significant delays at this point.

Yes, I think we feel comfortable, Paul, is the bottom line.

Great. If I could quickly ask about the nice uptick in new customer win rates and renewal rates. How have those conversations progressed now that commodity prices have proven to be more resilient?

I'm going to ask Jim McHugh to weigh in, but I think you've hit the nail on the head. Early on, and we saw this in the first quarter, renewal rates were down because our customers were naturally concerned this was a short-term bump. Now we see a lot more interest in renewals, some of which is just timing driven as contracts are ending. Customers are now recognizing the long-term change in energy pricing, and they're eager to lock in deals.

Yes, I think that's accurate, Paul. To get their budget certainty, customers are coming up on renewals and unable to delay their decisions any further. It’s clear to them and us that we are in a different energy landscape now, and they are more willing to lock in. We saw this during the second quarter with an uptick in renewal rates and longer terms compared to the first quarter. Both metrics indicate the shift Joe mentioned. Of course, these same customers are also discussing future products with us due to their focus on sustainability needs and energy footprint, so conversations are moving along positively.

It's actually James for Shar. Can you hear me?

Yes.

So, Joe, I wanted to start with your comments on growth in capital allocation and how that ties into the IRA potentially passing this summer. Would that shift your views around inorganic nuclear growth? And are you seeing any opportunities out there right now?

I've mentioned this before: with the IRA in play, it has been challenging to determine valuation. Sellers want to price in the IRA benefits. We've approached this cautiously optimistic, and we see the ongoing progress. The IRA provides a strong price floor under nuclear units, which narrows the bid-ask spread and allows for conversations we haven't had before. We're focused on acquiring assets as part of our inorganic growth strategy, contingent on pricing that makes sense. If any nuclear plant transacts, it’s reasonable to assume Constellation will be involved in the conversation. However, as of now, the pace remains unchanged, with people awaiting the passage before diving deeper.

Excellent. On the hydrogen side of the legislation, regarding capital allocation, could you begin spending growth capital in '23? Or is it primarily going to be technical pilot work?

In '23, any spending would be relatively modest compared to our overall cash generation as a business. I think capital in this area would likely scale up more significantly in '24.

Just a quick question. A lot of people are focused on pricing, but I noticed you and Duke had signed LOIs with Global Laser Enrichment over the last few months. With the increased focus on energy security and domestic supply production, how do you see bringing uranium back in terms of both production and enrichment in the U.S., and how might this technology play a role?

In terms of a U.S. strategy, I think it's wise for policymakers to incentivize more domestic production capability. This technology is exciting. Bryan Hanson, who runs our fleet, is here, and he might add some context to this.

It's crucial for the U.S. to reestablish itself as a leader in enrichment services. Currently, we have very modest domestic capabilities. We're observing a wave of new innovations, including GLE and a couple of other companies that are expanding enrichment services in the U.S. We aim to play an active role in that.

As a follow-up, these developments will likely take time to realize, but what kind of timeline do you envision for restructuring domestic supply and enrichment?

Most manufacturers estimate that the timeline is around 2026, with a target of reestablishing around 2028 to 2030. Through our ongoing contracts, we feel secure regarding our fuel position.

I was wondering, if you secure the nuclear PTC, is there a baseline EBITDA and cash flow level that you expect? If all plants received the PTC at the low 40s per megawatt hour level, what impact would that have on your stable, low-risk, derisked EBITDA profile?

David, we’re working through that. The legislation still hasn't been finalized, and we want to see the final language. Even after ratification, some parts will require treasury interpretations for clarity. The first year this will affect us is '24, which is outside our current guidance.

Yes, it's important to note that we don’t have all the data points to establish that baseline yet. I’d prefer to hold off on discussing profits until we better understand how this applies.

Understood, that's fair. Just a follow-up on retail margin pressure. Could you quantify how much that’s impacting EBITDA and how it might rebound positively in 2024?

Yes, I think the key point is that this trend is unprecedented historically. We remain comfortable with our guidance for the year, so I wouldn’t overemphasize it. The renewal is on track, and customers are looking to incorporate risk pricing into their contracts. This remains a minor aspect, with no changes to our disclosures.

Got it, that’s helpful. Lastly, could you discuss how the 2024 hedge level is shaping up in terms of how much you layered on over the quarter? Will it be similar to what we've added for 2023?

Yes, David. I’ll ask Jim to explain our current position, but I’d like to clarify that the prices we levelize will lead to recovery in later years. We're not signaling any losses here. Jim, please provide the details.

Thank you, Joe. Regarding the 2024 hedging question, I want to highlight our current situation: as noted at Analyst Day, we started with about a 27% hedge level, including the CMC structure. With the New York ZEC mechanism, where prices are shifting, that begins to hedge a portion of our portfolio. Talking numbers, we were at about 52% hedged in '24 at our last update. In the past quarter, we added a similar amount of hedges for both the '23 and '24 years, moving us to about 70% hedged now. There’s still 30% of our portfolio open, participating in market conditions. The hedging activity stems largely from customer business and the forward markets, striving to create reliability and stability in our EBITDA projections.

Guys, can you hear me?

We can, Jonathan.

Just a quick question to kind of ease off the discussion about 2024 and hedging. As you read the IRA legislation as it currently stands, what is likely to drive the PTC? Is it a market-clearing price or a hedge? How is it determined?

Yes, Jonathan, it could be either. That’s how treasury may ultimately interpret it—either as a hedge or at the spot price. When I referred to the treasury interpretation we’re seeking, that’s one area we are focused on. Generally, we believe the hedge should be one of the measures for determining the value of the PTC. Our business relies on this, as stripping out nuclear baseload availability from utility procurements would hinder the ability of our clients to secure reliable energy supply. Treasury has previously accepted hedge values for tax purposes, and we believe they will apply here to facilitate load options for utilities. We will make these points to treasury, and we are confident they will accept it, although it remains an unresolved issue.

So the bill isn't definitive and will require work after passage.

Yes, that’s accurate. The language we read is open to either interpretation.

Lastly, regarding capital allocation, you mentioned providing updates later in the year. Was there any more specificity on that?

What I meant is this: should the IRA pass and enact in September, we want to assess the market reaction to see if it reflects the transformational value the bill brings to our business. This will inform our cash utilization strategy. We’re committed to providing that information before the end of the year, potentially during the third quarter call or between the third and fourth quarter calls. We haven't finalized that yet.

I want to thank you for starting the call and for your colorful remarks throughout. I appreciate everyone who has listened in and the great questions we've received. Thank you very much, everybody. Have a great day.